Magazine

Master Of The Options Universe

October 22, 2006

Companies from Apple Computer (AAPL) to UnitedHealth Group (UNH) to McAfee have played games with stock option grants in recent years, often to the detriment of shareholders. The list of techniques that can be used to boost the value of options received by executives, or to minimize the cost that must be reported, is long, from repricing or rejiggering the estimated value of an option to so-called speed-vesting, backdating, spring-loading, and more.

But amid that litany, one company stands out: Norwood (Mass.)-based semiconductor maker Analog Devices Inc. (ADI) Not only has it used each and every trick in the book, its profits have gotten a bigger boost from several controversial techniques than all but a handful of companies. "It's rare that you get a company taking advantage of every loophole possible to maximize the return to executives at the expense of shareholders," says Robert McCormick, head of proxy research at Glass, Lewis & Co., an advisory service for institutional shareholders. "But they appear to have taken the [everything but the] kitchen sink approach."

Start with the practice of accelerated vesting. U.S. companies had to begin deducting the cost of their options from income starting in fiscal 2006. By pushing up the vesting of outstanding options ahead of that deadline, however, some avoided a big charge. Last October, Analog speed-vested options valued at $188 million, which pumped up its 2005 aftertax income by $134 million. Only Viacom Inc. (VIA) and Sun Microsystems Inc. (SUNW) boosted earnings more from accelerated vesting, according to Jack T. Ciesielski, publisher of The Analyst's Accounting Observer.

Like many companies, Analog also has trimmed options expenses by tinkering with the formulas used to value them. That's doable because the expense deducted for an option is simply an estimate based on assumptions about such things as how volatile the underlying stock is or how long holders will hang on before cashing in their options. The more favorable the assumptions, the lower the costs. While such changes can be legitimate, analyst David Zion of Credit Suisse warns that big shifts can also be red flags for aggressive accounting.

The sums involved are hardly pocket change. Zion points out that in 2005, Analog slashed its estimated options volatility from 69.2% to 27.4% -- the biggest drop among S&P 500 companies. With that move alone, he estimates, Analog reduced the cost of its 2005 options by $173 million -- an amount equal to 31.6% of its operating income. Only Intel Corp. (INTC) earned bigger savings from making such a shift.

Analog also gained considerably by reducing the expected life of its options. By cutting the time it thinks employees will hold options from an average of 5.8 years to 5 years, Zion figured the chipmaker trimmed costs by an additional $20 million. Only five companies pocketed bigger gains from this change.

Analog spokesperson Maria Tagliaferro defends the company's practices. Since the price at which many of the options could be exercised was well above the stock price when the speed-vesting occurred, she says the expense associated with them was out of line with their real value to employees. And she says the new volatility estimates -- a measure of the "implied" future volatility based on the price Analog's options get in the market -- are more accurate than the old figures, which reflected Analog's historic volatility. Likewise, she adds, the shorter holding period is a truer number than the old one.

The semiconductor maker was also one of the first to be caught up in the options backdating scandal. Backdating is when companies claim options were doled out earlier than they really were, to provide a bigger payoff for recipients. A related practice, called spring-loading, involves issuing options just ahead of good news, so that the value of the option is virtually guaranteed to bounce. Roughly 140 companies have either launched internal probes or are being investigated by the Securities & Exchange Commission or the Justice Dept. for options timing misdeeds.

Last November, Analog and CEO Jerald G. Fishman agreed to settle civil fraud charges that the company had engaged in both backdating and spring-loading of the options it granted to directors, executives, and other employees on several occasions from 1998 to 2001.

Under the tentative settlement, which Analog and Fishman have agreed to without admitting or denying guilt, the company would pay a $3 million fine and would reprice some options given to Fishman and other directors during those years. Fishman would also pay a fine of $1 million and disgorge gains from some options sales. The settlement, however, has never been finalized. In May, the U.S. Attorney also began probing the same issues.

The company's use of controversial pay practices goes back many years. In 1998, following a slump in the stock, it repriced a big slug of options, a tactic long criticized by investors. And last February, Analog ran into a storm of criticism when shareholders found out that the company owed Fishman $145 million in deferred pay built up since 1995, much of it from gains on stock options. Analog also paid Fishman and others interest at better-than-market rates. Fishman pocketed $8.7 million in interest on his stash in 2005 alone.

Such practices have intensified scrutiny of Analog. Last spring, Glass Lewis gave Analog an "F" on pay-for-performance. Along with rival proxy adviser Institutional Shareholder Services, it urged institutional investors to withhold support from director James Champy, a compensation committee member. The well-known management guru received the backing of only 73.6% of the votes -- a big sign of shareholder unrest. Chairman Ray Stata says Analog has modified some of its practices. Repricing is no longer allowed, for example, and it now issues options on the same date every year. He adds that the company openly communicates with shareholders about the decisions it makes on compensation; after that, it's up to investors to decide what to do with the stock. With shares off about 27%, to $30, since February, it looks like many already have.